The (un)importance of cash flows

I’m seeing a lot of discussion on defined benefit cash flows at the moment. Some of the commentary on the importance of cash flows is sensible; some is questionable; and some is plain wrong.

What do we mean by cash flows?

When talking about cash flows for a defined benefit pension scheme, we generally mean the amount of money coming into the scheme versus the money being paid out. The money coming in is usually taken to be contributions, with investment income usually added; the money going out is mostly in respect of benefits, with expenses also being included. If cash in is greater than cash out, a scheme is cash flow positive; if the opposite is true, then it is cash flow negative.

The true importance of cash flows

If a pension scheme is cash flow negative before allowing for any investment income, it needs to plan to have cash available to pay benefits. This reduces the extent to which it can invest in illiquid investments. This is important because illiquidity carries a premium – an investor can expect a higher return in exchange for tying up money for longer, or even just investing in assets that are more difficult or costly to sell. This additional return is not necessarily that high. Even for the least liquid investments, which may have a small unit size and carry a significant governance weight, the premium may be a few percentage points. But this premium is for investments with contractual cash flows – in other words, the type of investments that could be expected to match liabilities. These might include only slightly less liquid assets like corporate bonds, all the way to private credit – but in all cases, you know what cash flows you’re supposed to be receiving.

However, even a cash flow negative pension scheme can take on a significant degree of liquidity risk. Although benefits are being paid, these benefits are largely predictable. This means most pension schemes should be able to benefit from investment in illiquid investments.

A more questionable view

Some would take the illiquidity argument further. They would argue that if you can tie up investments in risky assets – particularly equities – for long enough, you can benefit from time diversification. This is the idea that the longer you hold an investment, the less risky it gets.

There are several flavours to this point of view. The first is that short-term stock market volatility is just noise. Supporters of this view give the relative stability of dividends as an example of the excessive noise in stock markets. But dividends are deliberately smoothed by companies, and if earnings fall dividends can (and do) fall too. Earnings are also less volatile than share prices. But (1) this does not mean that future earnings are “knowable”, (2) the direction of future earnings could be drastically different from that expected, and (3) the share price allows for and capitalises this uncertainty over the future, which explains why it is volatile – but rightly so.

A more nuanced view is driven by the way in which volatility does increase over time. The theoretical view of equity volatility is that it increases with time horizon in a very specific way: with the square root of time. In other words, the volatility over 4 years will be twice as big as the volatility over 1 year.

But some note that the volatility does not rise as quickly as this rule implies – so long term investment results in a free lunch for equity investors. But even if this rule does not hold, the volatility of the final value of an investment still grows over time. Is the expected return high enough to justify this still significant risk? Or is the potential downside still so catastrophic that investment in risky assets should be treated with caution? There is no way of knowing in advance. However, this ever increasing level of risk is in stark contrast to the much lower levels of uncertainty seen in fixed income investments.

Plain wrong

But some people looking at cash flows focus on entirely the wrong issues. For example, they might point to a cash-flow positive scheme, or one where investment returns exceed cash outflows, and use this as a metric for a scheme’s success. But in this regard, the level of cash outflows is irrelevant. Take a (theoretical) young defined benefit pension scheme, with no benefits being paid out, and a contribution rate of 1% of salaries – a fraction of what would be required on any vaguely reasonable basis. Here, the cash flow would be positive, returns would exceed outflows, yet the scheme would still be heading for disaster.

Conclusion

Cash flows do matter to pension schemes. They should be allowed for, to ensure that the risk of forced sales is kept low, and that the capacity for liquidity risk is used to generate additional returns. But they should not be used to justify excessive investments in risky investments – unless sponsoring employers are happy to pick up the tab if things go wrong…